What You Should Know Before Taking a Loan from Your Life Insurance

One of the great things about permanent life insurance is that it builds cash value. Geber86 / Getty Images

Aside from the death benefit, one of the great things about permanent life insurance is that it builds cash value. Your policy becomes an asset you own.

As you build cash value in your policy, you can easily take a policy loan against those funds to use for an emergency like a house repair you didn’t expect or as a source for funds to pay for an opportunity like college. You can also take a policy loan to pay premiums on the policy, and if you elect an automatic premium loan option when you purchase the policy, the company will automatically pay any premium that you do not pay in cash with a loan against the policy.

Before taking a policy loan, it’s a good idea to speak with a financial planner or professional, as there may be other ways to meet your needs that make more sense for your situation.

THE PROS AND CONS OF A POLICY OR PREMIUM LOAN

Taking a loan from a bank can be a lot of work, especially today. You typically have to send W-2s, tax returns and other financial documents to find out whether you’ll even qualify to get money. On the contrary, provided you have the cash value available, policy loans are easy.

“You don’t have to go to a bank. All you do is fill out a simple form, and in a couple days you get the money from the insurance company,” said John O’Meara, an advanced planning attorney with Northwestern Mutual.

Repaying a policy loan is easier, too. Unlike most traditional loans, a policy loan does not have a fixed repayment schedule. If you want to make a large payment one month, you can. If you want to pay nothing one month, you can.

The ease of taking and repaying policy loans does not mean that policy loans do not have to be paid back. They do. They can be repaid in cash, or they will be repaid from policy values. That means any loan balance will be repaid with death or surrender benefits, reducing the proceeds paid out on a death claim or if the policy is surrendered. If you pay off the loan, the full benefits of the policy will be restored.

You don't have to go to a bank. All you do is fill out a simple form, and in a couple days you get the money from the insurance company.

A NEGATIVE TAX CONSEQUENCE

One of the common misconceptions about policy and premium loans is that you’re borrowing your own money. You’re not.

“With a life insurance policy loan, you’re actually going to the insurance company and borrowing money and then using the cash value of your policy as collateral,” O’Meara said. It’s very similar to a home equity loan. “You still own your home; it still has the same fair market value, except your equity is now reduced because you have borrowed money from the bank.”

If you don’t make payments on a policy loan, interest will accrue; and if the interest is not paid, it will be added to your loan balance, increasing the amount you owe. At some point, if you don’t make payments on the principal or interest, the loan balance could become equal to your policy’s cash value. At that point, your policy will lapse, and two things will happen. First, the insurance company will surrender your policy. Second, the company will use the cash proceeds from the surrender to pay off the loan balance. In most such cases, you will not receive any surrender proceeds from the policy.

So what’s the tax consequence? To explain, let’s talk about the first step and assume there is no loan. Let’s say you have a policy with a cash value of $200,000. You paid $90,000 in premiums over the years. If you were to surrender your policy and walk away with the cash value, you would recover the $90,000 you paid in, tax-free. The $110,000 gain, however, would be taxed. If you were in a 30 percent tax bracket, that would result in you owing the government about $33,000. You would walk away with $167,000 after you paid the tax.

Now let’s add the loan. Say you borrowed $100,000 and never made any repayments. The interest would compound, and in the ensuing years, if you never repaid any of the loan interest and/or principal, your total loan balance would approach the total cash value. Once the total loan balance equaled the cash value, the policy would lapse, and the company would terminate, or surrender, your policy (step 1) and use the proceeds to pay off the loan the company gave to you (step 2).

From a tax perspective, the first step is treated the same whether the money is used to repay the loan balance or taken as cash with no loan involved. You owe $33,000 in income tax. From an income perspective, you owe $33,000 in tax but receive no surrender proceeds from the policy with which to pay the tax.

There is no reason for this result to occur. If you manage your policy or premium loans and take the appropriate steps, you can enjoy the benefits of the loans and avoid the risk of lapse. Here are some tips:

Monitor your loan balance in comparison to your cash value.

Make regular payments on the loan.

Pay the interest on the loan in cash.

If you are unable to repay your loan, talk to a financial professional or call your insurance company to discuss your options. You may be able to pay down your loan with policy values or dividends.

Policy and premium loans are important benefits of permanent life insurance. As long as these loans are understood and managed properly, they can be an easy and fast source of cash without the risk of unexpected and unwanted tax liability.

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Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company and its subsidiaries. Life and disability insurance, annuities, and life insurance with long-term care benefits are issued by The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM). Long-term care insurance is issued by Northwestern Long Term Care Insurance Company, Milwaukee, WI, (NLTC) a subsidiary of NM. Securities are offered through Northwestern Mutual Investment Services, LLC, (NMIS) a subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Fiduciary and fee-based financial planning services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with the titles "Financial Advisor" or "Wealth Management Advisor" are credentialed as NMWMC representatives to provide advisory services.